A (Brief) Free Market Case for Tariffs

First, let’s sum up and get out of the way one clear area where tariffs make free market sense:

·         Retaliatory – When a nation imposes tariffs on US goods and services, it is only right that we should impose like tariffs. Unfortunately, there are many cases where this has not been US policy. A small book could be filled with examples, but one to illustrate is motorcycles between the US and India. Historically, Indian tariffs in this arena have been as high as 75%, where the US standard import duty on motorcycles is around 2 – 3%.[1]

As Adam Smith wrote in “Book IV, Chapter 2” of The Wealth of Nations:

“The case in which it may sometimes be a matter of deliberation [whether to impose tariffs] is, when some foreign nation restrains by high duties or prohibitions the importation of some of our manufactures into their country. Revenge in this case naturally dictates retaliation.”

Along with retaliatory tariffs—as mentioned in the quote above—Adam Smith made the case for two other clear instances where the imposition of tariffs makes absolute economic sense, even for a nation which supports free market capitalism. The first instance is in the case of national defense; the second instance is when there is some tax imposed in the home country which the foreign importer does not have to pay. It is this second instance where I believe the clearest case can be made for the imposition of a broad swath of tariffs, though the economic reasoning to arrive at this conclusion is slightly nuanced.

·         In the case of national defense, Adam Smith lays out the clear example of why Britian must maintain its shipping industry for both commercial and economic reasons related to national defense. Regardless of how much cheaper someone may be able to sell to Great Britian ships, it was clear and imperative to Adam Smith that Britian could ill afford to become dependent upon another nation to navigate the globe. Again, there are unfortunately a number of key defense-related goods and services where the US is wholly dependent upon foreign suppliers, including in the area of rare earth minerals and elsewhere.

Taking retaliatory and defense-related tariffs as permissible for the free market capitalist, one may ask: What about tariffs on other goods, goods where tariffs are already in line between nations and where the good has no clear connection to national defense? To answer this question, one must look closely at Adam Smith’s reasoning and expand it to encompass today’s economic reality.

Smith also writes in “Book IV, Chapter 2” of The Wealth of Nations:

“The second case, in which it will generally be advantageous to lay some burden upon foreign for the encouragement of domestic industry is, when some tax is imposed at home upon the produce of the latter. In this case, it seems reasonable that an equal tax should be imposed upon the like produce of the former.”

In other words, when the production of some good at home is taxed in a way it is not taxed abroad, it is right to lay tariffs on this imported good equal to the tax being levied at home.

For the purposes of this short article, I would like to expand our notion of tax. Particularly, I propose that US industry pays three taxes which most other nations, especially developing countries, do not pay.

·         An environmental tax – the US adheres to strict environmental guidelines in its production that are simply minimal or non-existent in many nations. I will refer to this at ET or the Environmental Tax.

·         A cost-of-living tax – the US adheres to labor laws and minimum-wage regulations that, again, are minimal or non-existent in many nations. I will refer to this as CoLT or the Cost-of-Living Tax.

·         A reserve currency tax – this tax is the most nuanced, but it definitely exists. As the world reserve currency, the US dollar (“USD”) is over-valued relative to what would be its natural exchange rate were there not an artificial demand for USD around the world. This reserve status creates what is in effect a tax on US labor. I will call this RTL or the Reserve Tax on Labor.

In fairness, it must also be acknowledged that the reserve status of USD also reduces the cost of globally traded commodities for US residents, such as oil and gas. This effect, I will refer to as RSC or the Reserve Subsidy on Commodities.

Given the above framework, we can construct an equation for what I call the ALT or Appropriate Level of Tariff. All other things equal:

ALT = ET + CoLT + RTL – RSC

This ALT equation could be used as a guide to think about what appropriate tariffs may be on goods and services that do not squarely fall under the retaliatory/national defense exceptions that Smith writes about in his famous opus.

For example, ET would be low or non-existent for goods that have very little environmental impact during production. If these goods are also low on labor costs due to automation, the CoLT and RTL would also be low. The more commodity heavy the input costs, the greater the RSC would be and thus reduce the ALT. Hence, there may be some goods for which no or low tariffs are appropriate. However, there are also many goods, such as steel production, where the ET, CoLT, and RTL may be significant and clearly not entirely offset by the RSC. In this case a significant tariff may be warranted, even from a free market perspective.

In conclusion, it is worth noting one other argument against tariffs, namely, inflation. Here, I think there is also a good framework which acknowledges the inflationary impulse of tariffs but justifies their impact. It will be discussed in a second short article devoted to current inflation concerns.  

PDF version of this post available here: A (Brief) Free Market Case for Tariffs

[1] India ready to cut tariffs on Harley-Davidson motorcycles? Piyush Goyal responds - India Today